Oct 27, 2008
Executives
Robert Noorigan – Vice President – Investor Relations E. Hunter Harrison – President & Chief Executive Officer Claude Mongeau – Executive Vice President & Chief Financial Officer James M.
Foote – Executive Vice President – Sales & Marketing
Analysts
Jason Seidl – Dahlman Rose & Co. Christopher Ceraso – Credit Suisse Jacob Bout – CIBC World Markets Edward Wolfe – Wolfe Research LLC Randy Cousins – BMO Capital Markets Analyst for Thomas Wadewitz – J.P.
Morgan David Newman – National Bank Financial William Greene – Morgan Stanley & Co. Walter Spracklin – RBC Capital Markets Bill Mackenzie – TD Newcrest Chris Weatherby – Merrill Lynch Cherilyn Radbourne – Scotia Capital David Feinberg – Goldman Sachs & Co.
Operator
Welcome to CN’s third quarter 2008 financial results conference call. I’d now like to turn the meeting over to Mr.
Robert Noorigan, Vice President – Investor Relations.
Robert Noorigan
Welcome to CN’s third quarter financial results. I would like to remind you about the comments that have already been made about regarding forward-looking statements.
With us today is Mr. Hunter Harrison, the President and Chief Executive Officer of CN along with Claude Mongeau, the Executive Vice President and Chief Financial Officer and Jim Foote, Executive Vice President of Sales and Marketing.
After our presentations, we’ll take questions for those of you who are listening on our call and if you could please identify yourself when asking the questions, in order to be fair could you limit the number of questions that you ask to two or at most three. With that it’s my pleasure to introduce Mr.
Hunter Harrison, CN’s President and Chief Executive Officer.
E. Hunter Harrison
Thanks to everyone for joining us this afternoon. I am proud to be able to report what I think is a pretty remarkable quarter in the environment that we’re operating in today.
Let me just highlight a few issues and then I’ll turn it over to Claude and Jim to get in more levels of detail with you. But our revenues were up 12%; pretty solid overall growth.
Our operating ratio returned to levels that we’re used to at effectively flat year-over-year at 62.6%. Our diluted EPS of $1.16 as reported was up a set 21% but that includes a 9% deferred income tax recovery.
If you look at it on a same store basis year-over-year, EPS was up 15% or $1.07 compared to $0.93 last year. So overall pretty solid results in the environment as I said earlier we’re operating in but the thing that I’m so pleased about is the impact this will have going forward.
We broke records just about across the board in all our operating metrics which I thought was a pretty outstanding performance. Our cars, switching productivity was up 6%.
The run rate as we speak on our train speed is up about 12%. Our active car inventory is down about 11%.
Our gross ton miles per available horsepower was up 8%. Our car miles per car day was up quarter-over-quarter about 6% and I would expect in the fourth quarter that to move up significantly.
So these are operating metrics that Keith’s team has achieved that we can look forward to and will serve us well going forward. If we go through some tough times it will solidify our position as a low cost carrier and put us in a good position to deal with adversity as it might come in the future.
So overall I was extremely pleased and let me turn it over to Claude to go through and analyze some of the numbers with you before Jim talks about revenues.
Claude Mongeau
Those were indeed very solid results and they were achieved in a challenging environment. We delivered $1.16 of earnings per share on a reported basis.
That’s an increase of 21% over 2007. If I exclude the $41 million of deferred income tax recover, which we have booked in the quarter, EPS is $1.07 up 15% over last year and basically I have to say we’ve executed well on all key fronts to achieve this kind of performance.
Our revenues were up a full 12% and that’s despite the double digit volume declines in three business units that are affected by the economy: forest products, autos, not by the economy but grain was also down during the quarter. And we achieved the solid volume growth to offset that in three of our business units as Jim will explain to you in the coal, metals and minerals and intermodal.
We’ve obviously had the benefit of higher fuel surcharge but also solid pricing environment continuing. But it’s not enough to deliver the top line; you have to bring it to the bottom line and that’s what we did during the quarter.
Very solid railroading, as Hunter discussed, helped us drive good productivity but also very strong network velocity. I’ll give you a few statistics in a minute.
So operating income on a year-over-year basis up 10% and our operating ratio came in at 62.6%. That’s only 60 basis point increase over last year.
All in all this basically underscores the kind of performance that we can achieve when the foreign exchange and the fuel surcharge lag, which were impacting our results in the first half of 2008, start to subside. Let me turn briefly to the expense performance.
Overall, very solid performance. Our expenses increased only 2% if I exclude fuel.
Fuel was obviously a headline increase with $140 million year-over-year increase. That’s a 55% increase.
We were able to offset price with very solid fuel consumption improvement; almost 2% fuel consumption improvement and volume helped us make the difference between the 60% price increase and the 55% reported increase in fuel expenses. Labor expenses were very well behaved with a 5% reduction.
We had stock based compensation decline due to the stock price but that was offset by a higher bonus accrual for our normal incentive plan for management for the year. Wage inflation was offset by productivity and also a slight head count reduction so very strong management on this front.
And the benefit that you see of roughly $20 million or $22 million decrease is the benefit largely of our pension expense coming down by $18 million per quarter. Both purchase services and material and casualty and other were up 9% on a year-over-year basis.
Purchase services was $20 million higher, largely driven by the third party carrier cost of our CN WorldWide activity and also to a much lesser degree our equipment repairs which were up slightly on a year-over-year basis. Casualty and other was up $8 million.
The increase is roughly half and half between that dip and the fact that we have slightly higher environmental costs or environmental accrual for the cost of certain sites. So overall, the performance is very, very strong as Hunter mentioned.
We had network velocity records during the quarter both in terms of car velocity but also locomotive utilization. And basically that kind of performance is what allowed us to maintain our expense performance and bring the top line to the bottom line in a fashion that we were able during the quarter.
Turning to free cash flow, after nine months year-to-date we generated $483 million of free cash flow. The increase in the third quarter alone was significant; we generated $258 million during the third quarter versus $142 million last year.
This basically puts us in a very good position to finish the year around our target of $650 free cash flow for the full year. I have to tell you as a CFO of CN in these turbulent times in the financial market, it’s good to be running a company that throws off solid cash and also has a strong balance sheet.
We have the balance sheet and the cash balances to pursue our strategy whether it’s investing in our business, although we will be looking at our capital expenditure very carefully into next year. We have the ability to fund our productivity and our growth initiative.
We have the ability to fund our strategic initiative like the funding of the EJ& E transaction which we’re hopeful to close on before year end. And we also have the ability to continue to reward our shareholders with a share buyback and our dividend policy going forward.
Just to wrap up in terms of the outlook for the business environment I have to tell you obviously when you look out there, there’s a lot of uncertainty but near term for 2008 specifically we are in very good shape. The business through October is holding up.
Our operating metrics are very good; in fact they’re improving over Q3 and we have the benefit of the headwinds that we had faced in the first half of the year subsiding. Foreign exchange at $0.85 and the world oil prices around $75 obviously gives us benefits.
In fact, if I add those two into the fourth quarter it could be as much as $0.10 in terms of EPS tailwind. So we’re in good shape to finish 2008 and longer term for 2009, although the environment is more difficult to call and we’re not going to provide you with specific guidance given the uncertainty about the economy, we feel very good about how we are positioned.
The financial markets are stabilizing. They were fine only a few weeks ago when things were looking dire but things seem to be stabilizing now.
I was looking at spreads earlier today, they’re coming down. All of the concerted efforts across the world from government and the central banks seem to be stabilizing the financial market and the question in front of us at the moment is really what will happen to the real economy.
It is difficult to call; so far as I said we’re not seeing meaningful impact on our business but there is a likely slowdown into 2009. The question is will it be a V-shaped slowdown that will take six to nine months or will it be a longer slowdown, more of a U-shape that could take longer?
We don’t know that for sure either way; what we do know is that we are very well positioned. We have a very focused management team.
We can focus on the adversity as Hunter mentioned but we are also positioned to rebound when the economy comes back. We have a strong franchise and as Jim will tell you in a minute, we have a very long pipeline of structural growth opportunity and we feel very good that when the economy clears we’ll be in a position to show very strong results going forward.
With that I’ll turn it over to Jim.
James M. Foote
I’d like to go through the revenues in the third quarter now in a little more straightforward presentation this quarter as there is no impact from exchange. Top line is that revenues were up 12% this quarter compared to the third quarter last year.
From a volume perspective on a carload basis we were up 1%. I think these are pretty good results.
The highlights of the volume side were the growth in almost every sub-category of our metals and minerals group, higher U.S. coal volume and the new Prince Rupert intermodal volume.
These three areas offset the slower Canadian wheat which was down due to the small 2007 crop as well as the small carry forward and the continuing slow volumes associated with the downturns in the automotive as well as the lumber and panels market. On the yield side in the third quarter, yield again improved.
Revenue for revenue ton mile was up 14% and our revenue per carload was up 10%. About 60% of this yield improvement comes from the higher fuel surcharge recovery due to the higher crude oil and fuel prices and the rest from price increases.
Same store per unit prices were again up in the 4% to 5% range. Other revenues increased 13%, reflecting our focus on growing non-rail transportation services.
Taking numbers apart in a little greater detail, petroleum and chemicals solid results this quarter attributable to growth in several areas which were offset by some slower production from our Gulf Coast customers due to the impact of the hurricanes. On the petroleum side, dealing with volumes in the Western Canadian oil sands area continue to grow impressively and sulfur movements to the U.S.
markets were strong. These gains were offset somewhat by slower plastic pellets and the associated feed stocks due to some business changes and some plant closures.
The chemical side of the business was softer than the petroleum segments due to weakness in industrial chemicals tied to the panel production as well as the auto production. Metals and minerals up 29%.
As I said, there was growth across the board in this group. On the metals side there were increased shipments of flat roll product, the movement of large diameter pipe related to specific projects and increased volumes of scrap.
Minerals side, commodities related to the development of the oil and gas industry such as the aggregates that we’re shipping into the Upgrader Alley in Alberta as well as increased volumes of sand and cement related to some drilling activity. And iron ore very strong in the quarter related to the overall strength of steel in the segment.
Forest products down 2%; lumber and panels obviously continues to struggle. The only good news is that our year-over-year comparisons continue to improve.
Lumber and panels carloads were down 22% this quarter. Paper and pulp is doing somewhat better.
This is due to increased log shipments and some new business that we’ve been able to bring on to offset some of the plant curtailments and closures. Automotive up 3%.
There we’re seeing some increased traffic, some import traffic through the ports of both Vancouver and Halifax which is offsetting a little bit this decline in the shipments from the North American manufacturers as they continue to rationalize capacity and cut back on production. Coal here up 41%, virtually all of this related to the production from the new mine that we’ve talked about in the past coming online in the Illinois basin as well as some increase in some western coal traffic that we receive from interline partners for delivery into the U.S.
On the grain and fertilizer side, the results have been impacted both in Canada and in the U.S. from late harvests as well as the low carry forward for the crop in Canada which I talked about.
Fertilizers was down somewhat as we had good shipments of fertilizer in the U.S. which offset some of the decline that we saw from potash shipments in Canada.
And on the intermodal side of the business, increased volumes from our existing customers calling Prince Rupert there helped drive results intermodal in total of being up quite a bit, 24%. And the domestic business also doing well as we continue to gain share from trucks in both the Canadian retail market as well as the transborder market, both southbound and northbound flows.
So if we look forward a little bit and on the next page talk a little bit about some of these structural growth opportunities that we have and continue to focus on and which are delivering results not only in the third quarter but I believe that as we move forward. Intermodal we’re going to continue focusing, focused on growing the intermodal franchise both overseas and domestic, leveraging the structural efficiencies that we have with our ports and taking and selling the modal advantage that we clearly have in the domestic market.
On the merchandise side of the business, the oil sands is going to continue to provide us with a lot of opportunities as well as other gas and oil related projects that are being developed in that region. And on the bulk side, clearly a good franchise both north and south.
Very good crops and good quality crops in Canada and the U.S. The Illinois coal is taking off and is going to continue to grow and we have a lot of opportunities to work on the fertilizer side of the business.
The last page, again a little broader perspective in terms of pricing. The pricing environment remains solid.
We have a very good business model which is designed to sell service, not sell this transportation as a commodity. And the price ranges that we’ve talked about in the past, this 4% to 5% continues to exist.
I believe that the specific initiatives that we talked about will continue to provide us with opportunities to have volume growth even in these difficult times and we will continue to focus on our non-rail activities as an opportunity to both grow the business, which we saw in this quarter, but also provide us with a greater advantage in terms of selling our service to our customers across the board. So with that I’ll turn it back to Hunter.
E. Hunter Harrison
Just that these times are give this group a real opportunity to shine. It’s the tough times that we can really differentiate between this franchise and others.
You’ve clearly going to see short term and long term focus on continue to drive productivity, to sustain our pricing discipline. To continue to focus on market share growth to kind of offset some of the storm if you will and I think we’re well positioned to move forward and I feel very good about this.
Look, this is a excellent franchise with a wonderful operating model and a group of great railroaders that know how to execute day in and day out so I feel very, very good about the fourth quarter and I feel very, very good about next year in spite of some of the issues that we’ll have to deal with. So with that we’ll be glad to take questions the group might have.
Operator
We’ll now take questions from the telephone lines. (Operator Instructions) Your first question comes from Jason Seidl – Dahlman Rose & Co.
Jason Seidl – Dahlman Rose & Co.
A couple quick things. When we’re looking out in the 2009 in terms of Prince Rupert, given that there’s a lot of excess capacity in the West Coast ports, should we assume that there’s going to be no additional ships calling on Prince Rupert or with the service advantage that it has do we still have an opportunity to grow that base?
James M. Foote
Yes. I think as we look out into 2009, our existing customers have come to appreciate the value of the service that we have over Prince Rupert, both into Eastern Canada and into the U.S.
and continue to talk with us about ways to grow the volume so I would expect that that will continue to happen as we go forward into 2009. But our challenges there are much greater as I said earlier.
Our challenges there are much greater today than they were say a year ago when there was very limited capacity on the West Coast. Intermodal volumes in Canada for the two Canadian railroads continue to outpace the U.S.
railroads and we continue to lead the pack in Canada and I would think that that will continue.
Jason Seidl – Dahlman Rose & Co.
Jim, I guess I’ll ask for a second question; I’ll stay on the intermodal topic. You mentioned you’re still gaining shares from the truckers.
Could you give us a little more color? Can you talk about the length of haul that you’re gaining the market share on the truckers and how you’re doing and then maybe call it 800 to 1,000 mile lane given where fuel’s currently at?
James M. Foote
On the domestic intermodal, clearly in the 800 to 1,000 mile range we have an advantage as our cost structure comes down. We’re trying to push that down really below the 500 mile range in order to be more competitive there and are having success, not just clearly from a cost perspective but also as we continue to offer a more retail focused product which allows us to differentiate ourselves in the marketplace.
And we have rolled out that retail model further in Canada and now into the U.S. and that’s helping us grow this business and will continue to help us grow that going forward.
Jason Seidl – Dahlman Rose & Co.
So let me get this straight. You’re taking market share under 500 miles?
James M. Foote
In the 500 mile range is clearly a much more likely scenario today than in the 800 to 1,000 mile range.
Operator
Your next question comes from Christopher Ceraso – Credit Suisse.
Christopher Ceraso – Credit Suisse
Just a couple of quick ones. Do you see any risk of the work or the projects going on in the oil sands or what crude oil price do you start to worry about that area?
James M. Foote
You know, that’s difficult for us to answer; that’s really for the oil companies to draw on their determination. Our assessment and that’s what this is, is our assessment of their activities are out there, that they will continue to go forward at oil prices that are jumping around even though they might get down into the mid-$70 range here.
But that they will do that possibly on a slower time frame than they did it in the past, not because there’s not a need for the oil but because by waiting a little bit they might be able to buy some of their steel etc. that are necessary for the development of these projects at lower prices and/or be able to pay lower wages as they go forward.
None of us here believe the long term viability of the development of the oil sands is in jeopardy; it’s just a question of timing and we’re working with these customers very closely in bringing in the construction materials today to build these facilities.
Christopher Ceraso – Credit Suisse
Mentioned in aggregate 4% to 5% price. Can you give us any color by commodity which ones were particularly stronger or weaker than that level?
James M. Foote
I don’t think there is any one that is particularly stronger or weaker. They’re all clustered around this area and it’s not fair to say that necessarily the business segments that are the most distressed is the area where they had the lower price increases; they are certainly areas where we are able to work with our customers because of our low cost nature to find new market opportunities for them and we continue to do that.
Christopher Ceraso – Credit Suisse
A quick housekeeping item. Can you give us the year-to-date performance in the assets in your pension fund?
Claude Mongeau
Yes. I think at the most it varies by day, Chris.
This morning was a good market internationally. I think minus 10% is not a bad number give or take over the current environment.
They’re clearly ahead of their peers in terms of performance and the good news is while we do have a large pension fund, we are one of the few pension funds which until recently was comfortably above in a surplus position from a solvency standpoint. So we’re riding the market.
We have a very strong investment division. They’re outperforming their peers and we’re all hopeful that the markets will clear and they’re going to come out strong.
Operator
Your next question comes from Jacob Bout – CIBC World Markets.
Jacob Bout – CIBC World Markets
Can you just comment on how the credit crisis impacted your relationship with your customers? I know we’re hearing some very wonky things out there when you take a look at grain inventory levels at the port and inability by the shippers to get their letters of credit.
Can you talk a little bit about how that relationship has changed and what you’ve done to offset some of this risk?
James M. Foote
Well, I guess some of the stories that we have heard anecdotally about some of the customers not shipping, I guess the best way to put it is some of our customers not shipping product to some of their customers because there were issues with credit. We have been unable to find any circumstance where a product has not moved because of that.
Clearly, just as we are or are watching all of our customers and our receivables on a much closer basis as we go through this to make sure there are no issues that come up in terms of the payment for our services. But I see no change in the relationship with our customers as a result of this.
Jacob Bout – CIBC World Markets
Second question then just on your share buyback. I think everyone’s been under pressure but your stock’s been under some pressure as well.
Any thoughts here on increasing your share buyback?
Claude Mongeau
Well, I think the first call on cash in the storm term here is to finance our [J transaction]. We’re hopeful that we’re going to get a good decision from the court and that we will be able to close on this $300 million transaction before year end.
Having said this we will be coming out of these results here in our blackout period. We will be opportunistic in the market.
We do believe that we have the strength in our balance sheet and the cash available that we can pace ourselves and continue to be in the market even if we have the [J transaction] coming in front of us.
Operator
Your next question comes from Edward Wolfe – Wolfe Research LLC.
Edward Wolfe – Wolfe Research LLC
A couple different things. First, Jim, could you talk a little bit about the timing of grain?
When does the grain start to come back? When do those volumes start to come back?
When do you expect them to be positive year-over-year?
James M. Foote
Well, I think we’re going to start to see as we go into November, on the Canadian side of the ledger, more grain begin to move and we’re seeing that some of the larger shippers out there are putting in orders now that will be above what we have had over the last couple weeks. This is a situation right now where a lot of the buyers of wheat are waiting to see whether or not those prices will go down and so there is some softness in the ordering.
On the U.S. side of the ledger, the corn harvest is well behind schedule as a result of the flooding problems that began the crop year but that is now beginning to come in and will help to increase our U.S.
grain volumes there. I would hope that in the next few weeks, is the best way to say it, our grain volumes will begin to get back to normal levels and we’ll see again flat results on a year-over-year basis because this is the time of the year when we run at maximum capacity.
So we’re not going to ever really outperform ourselves from the prior year; we just want to be able to perform at that maximum level during this maximum shipping period and hopefully we get back there the next two to three weeks.
Edward Wolfe – Wolfe Research LLC
So do you think flat to modest down volumes for grain is possible for fourth quarter?
James M. Foote
Again, on a year-over-year basis the fourth quarter is pretty much, we run pretty aggressively during that period of time and most of the variation in the year-over-year performance has got to do with weather issues or something like that, not demand. As the crop comes in, both in the U.S.
and Canada, in the fourth quarter everybody wants to move it; that’s a historical shipping pattern and we will try to get back close to that. It changes from year-over-year as I say more to do with weather issues and the timing of holidays, etc.
than it does to do with demand.
Edward Wolfe – Wolfe Research LLC
Claude, can you talk a little bit about head count? Head count was fairly flat; volumes are up.
Is that –
Claude Mongeau
Well, that’s basically in line with what we had indicated before, Ed. We are running over the period where we did the more aggressive insourcing of some of the activities although we’re continuing to do some of that in certain trades.
We are lapping over some of the increases in the running trades that we needed to do to make sure that we have the resources to run our trains and deliver the business so from this level we are now able to run a tight ship and manage our work force very productively. So I would think what you saw in the third quarter is a good indication of what you can expect going forward.
Edward Wolfe – Wolfe Research LLC
In terms of pricing visibility as we go into ’09, when you think about pure pricing, can you give some guidance towards where you see a range for that or what percentage of your business you have visibility to at this point?
James M. Foote
Well, I think the guidance that we’ve given in the past, as I said earlier, this year our range was 4% to 5% and we had looked for some upside there and my position right now is depending upon what unfolds over the next six months, that’s still a reasonable assumption on our part. And we do not have a lot of long term contracts so a big portion of our business or legacy contracts are a big portion of our business where we price in 2009 at those run rates.
Operator
Your next question comes from Randy Cousins – BMO Capital Markets.
Randy Cousins – BMO Capital Markets
I guess I’ll throw this as an open question. Maybe, Hunter, you can answer this.
Obviously, everybody is concerned about the state of the economy. You can’t control demand but I wonder if you could give us some indication of what you think the sensitivity of your organization is to shifts in demand.
So let’s say we had a 3% drop in volume. Would that translate into a 3% reduction in EBITDA or how should we think about the linkage between volume and profitability?
E. Hunter Harrison
Well, I think there’s a point. Randy, obviously there’s a point where you can’t do that; I wouldn’t try to tell you differently.
I think in those kind of modest numbers of 3% or 5% areas, we can make adjustments accordingly. We have been keeping a very tight rein on example on hiring given that we had some indications that we might move into a softer period.
We’ve got a hiring freeze on right now. If it wasn’t for these productivity numbers we wouldn’t be able to have the hiring freeze on.
But if that is increased, I feel pretty comfortable certainly from an operating expense standpoint that we can maintain the kind of EBITDA that we produced. Going forward in this environment would pretty outstanding.
Now we’ve got some contingency plans here. We have taken a look at the capital budget and once again we’re waiting for the smoke clears but we have identified potential $200 million in reduction in the capital budget without getting into basic capital of rail ties and what things that would affect the physical plant.
We have a Plan A, we have a Plan B and we have a Plan C and if we need to have a D we’ll have a D. And we’re able to make these adjustments I think better than most.
Randy Cousins – BMO Capital Markets
So it’d be fair to say then that the railroad’s ability to deal with a downdraft has probably never been better in its history.
E. Hunter Harrison
Absolutely.
Randy Cousins – BMO Capital Markets
My second question has to do with the coal business so, Jim, I wonder if you could give us some additional clarity on exactly what’s happening there. Your arc increase in coal was 24%; it was close to one of the best, it was one of the better arc increases.
What time is this Illinois volume and is it long haul business and can you speak to the growth potential that sits there? How do you see your coal franchise playing out over the next year or so because obviously thermal’s less sensitive to GDP than say metallurgical coal?
James M. Foote
Yes. This is the Illinois Basin coal development that we’ve talked about now for the last couple years.
Some new miners have come into this region and are aggressively developing new mines and the first of which came online early this year and has ramped up and will ramp up to a production run rate of around 7 million tons of new business a year. It is a business that is moving into the utility markets in the U.S.
Southeast and to a degree into the U.S. North Central region, as well as we have been bringing this down to the Gulf Coast as they have pursued some export opportunities.
That is going to continue to grow. It is on an average revenue per car basis higher than what we have realized in the past with some of the Powder River Basin moves that we deliver and that really has to do with the length of haul there where we have a lot of volume that we receive for delivery in and around the Chicago, Gary or Detroit where we’re just the delivering carrier.
And therefore, while we have good profitability on a good volume, it’s just really short haul moves so that’s why you see the spike on a per unit basis.
Randy Cousins – BMO Capital Markets
So looking to 2009 in terms of your coal business and again, this may be that thermal coal is probably less sensitive to what the economy is going to do, is this a business that can have 20% volume growth?
James M. Foote
Probably not in 2009. The next step up in this will be when another mine or potentially two come online in 2010 so there are a lot of activity there.
There’s a lot of development plans in the works but we’ll be in the step basis as those come online.
Operator
Your next question comes from Analyst for Thomas Wadewitz – J.P. Morgan.
Analyst for Thomas Wadewitz – J.P. Morgan
So I was wondering if, looking into fourth quarter looks like on a per worker basis, comp and benefits were down 30% last year. How should we look at that going forward for ’08?
Claude Mongeau
Well, it’s always difficult to predict quarter-to-quarter because the cost per employee depends on stock based compensation and a number of other items which are not related to normal wage inflation. Our normal wage inflation is in the 3%, 3.5%.
In 2008, every quarter we get the benefit of lower pension expense to the tune of around $18 million per quarter. That will continue into the fourth quarter.
Certainly, at this point in time if the stock prices stay at the current level there should be a benefit but I am very hopeful that with good results like the ones we had in the third quarter, maybe that solves the issue and you actually see an increase in our cost per employee which would not be a bad thing to have.
Analyst for Thomas Wadewitz – J.P. Morgan
And what’s the sensitivity to the stock price? What’s the way to frame that?
Claude Mongeau
It depends on whether it’s U.S. or Canadian dollar, Mike, it’s about rule of thumb $5 million per $1 of stock price movement.
Analyst for Thomas Wadewitz – J.P. Morgan
Could you possibly quantify the benefit from fuel surcharges this quarter?
James M. Foote
I think it’s quantified in the MD&A as two-thirds of the price being associated with fuel surcharge.
Operator
Your next question comes from David Newman – National Bank Financial.
David Newman – National Bank Financial
If you look out in the current environment, obviously it’s a very tough environment but you’re in terrific shape obviously free cash flows, balance sheet. Would you even though you’ve got EJ&E on tap here, would you look at other acquisitions to, and specifically on CN WorldWide, the take it event of the current environment and perhaps bolster that platform?
E. Hunter Harrison
I think that’s getting a little ahead of us. I think in the environment we’re in now we’d like to get the [J] behind us; see what this economy does, let things stabilize a little bit and then we would take under advisement opportunities that might present themselves.
David Newman – National Bank Financial
In the past, Hunter, you said strategically it’s an area where you’ve got your operations and house in order that the other areas of the supply chain are areas where you would look to perhaps improve the efficiency and free forwarding or what have you. Is it something longer term that you will look more aggressively at?
E. Hunter Harrison
Well, I think we’ll take this in incremental steps. The first step was CN WorldWide, both international and North America.
We’re in the freight forwarding business we hadn’t been in before. We’re in the owner/operator/retail business as Jim described in the U.S.
where we hadn’t been before. We’re into business that we’ve never been in so we are controlling many more links in this logistics chain and I think as we gain confidence that this is the right strategy to pursue, that we will continue to look at other opportunities to loop that chain fully.
Now what that presents in the future, probably one it’ll be post-Harrison so maybe it’s not for me to say but I think there’s opportunities down there.
David Newman – National Bank Financial
Claude, you mentioned about $.10 you’re looking into Q4 in terms of FX and in fuel but I’m looking at a map here in terms of $1.02 in Q4 last year and $0.85 right now, it looks like you’re almost there just on the FX alone. If you held the WTI as it stands today, what fuel tailwind could we see in Q4?
Claude Mongeau
I think you have to look at every aspect, David. We do have realized foreign exchange gain and losses that go through other income and you’re right, if it stayed at $0.82 it would be more than $0.05 or $0.06 but I think overall the fuel surcharge lag, which is now a benefit for us, and exchange.
If the dollar stabilizes around $0.85 and if fuel, WTI stay at $75, all in $0.10, just round number is not a bad number to use.
David Newman – National Bank Financial
Last one if I may, obviously the CN franchise is built for volume and as I look out into, maybe getting ahead of myself, but past the current market malaise and get into the 2010 period, could you see core pricing first of all increase beyond the current levels of 4% to 5% and operating ratios drop down to the 50s level again such that you could plow it back into the franchise? What’s your thoughts as volumes come back?
E. Hunter Harrison
Well, if we keep seeing the operating metrics the way they are and keep delivering the type of service that the operating group has provided for Jim and it’s not a commodity and it’s the real value out there, volume helps. Certainly in this business it helps the efficiencies and so is there potential to move into the 50s again?
Sure there’s potential to move there. It’s just how much growth you have and if we maintain that we don’t, we’re blessed we don’t have capacity issues except one place and that’s Chicago, Illinois.
We’re doing everything we can to address that.
David Newman – National Bank Financial
How do you balance that off against pricing, Hunter? At some point, you get down in the low 50s, I think you said in the past you didn’t want to drive it down too low.
How is that balanced off against pricing? Would you take pricing up beyond the current core level that you’re looking at today?
E. Hunter Harrison
Well, look, I’m a believer that the market gives you the price. You don’t determine the price; the market gives you the price.
This is not cost base. This is the market and you decide whether you want to play or not in that market.
I’ve said many times and will say it again, we’re not obsessed with operating ratio and with the high stakes cost capital intensive business, I’d much rather be at 65 OR and be a $20 billion company than I would be a $10 billion company at 60/59. You pick the number; all you have to do is do the math.
So there’s a balance between that growth and that discipline and what the marketplace will allow you to do.
Operator
Your next question comes from William Greene – Morgan Stanley & Co.
William Greene – Morgan Stanley & Co.
Hunter, I think in the past you’ve mentioned a couple of times that you had thought that U.S. rails were a bit expensive when we think about acquisitions and they’re a lot cheaper now.
And so as you look at the U.S., given your balance sheet and your operating model, I would think the economics of considering a larger merger would be so compelling now. What’s wrong with that thought process?
E. Hunter Harrison
Well, one, Bill, if I address this question I probably cannot go back to Chicago, Illinois because I’ve got enough problems there now. Really, we need to get this STB issue resolved as far as the EJ&E, get the EJ&E taken care of.
We have some structural issues with the law in Canada that talks about ownership, percentages of 15% and some other issues that don’t make it just as easy and probably the most important issue is this: I don’t know that anybody else that wants to dance right now. And so given that, we’re going to focus real hard on getting through this storm, getting this EJ&E transaction done and then I’ll leave a message here for this team of what I think we ought to do going forward as far as acquisition.
William Greene – Morgan Stanley & Co.
If I come back to the pricing comments that Jim made about 4% to 5% next year, if the economy is as bad as some think it could be, how do you avoid having conversations about price next year with your customers? I just don’t understand how you might be able to sustain that.
Is it just that they don’t have that many options and you’re the low cost and so you still have pricing power, if you will, a pricing umbrella against alternatives or how does that work?
E. Hunter Harrison
I think I will let Jim comment also but I think it’s the value of your product. It’s the value proposition; you’ve got a certain service offering at a certain price and they look at the competition and they say what is that service offering and what is that price and they pick the best one.
And it’s value related. Depending on what people, how they value carrying costs, these people are going to get in the environment they’re in.
If I were them I’d be looking at cutting safety stocks and inventories and getting my carrying costs down and speed and velocity is very, very important then. And that’s a value proposition and so I think if we continue to produce the kind of reliable service that our customers have become used to, that we can, not across the board but there’s going to be some ups and downs but generally speaking I agree with Jim that we can sustain those levels.
You can’t say, “Look, the economy is bad. I don’t want to pay the price for fuel.”
If you’re going to do business, you’ve got to do business and you make that choice. Our suppliers don’t allow us to say, “Times are tough so cut the rates.”
They are not very sympathetic there.
William Greene – Morgan Stanley & Co.
One last question. Just when you look at your total volumes, how much do you think is related to all automotive business, sort of in and out everything that you would think is automotive related?
James M. Foote
Bob thinks it’s about 7% which would be about 5% for the business unit plus the parts, etc. that are moving in containers, etc., plastics.
That’s pretty much our estimate.
Operator
Your next question comes from Walter Spracklin – RBC Capital Markets.
Walter Spracklin – RBC Capital Markets
Just wanted to focus a bit on your operating efficiency improvements there. Pretty remarkable here.
Only a 60 basis point decline despite fuel going where it is, is much better than we had expected. Just wondering, can you touch, Hunter, I don’t know if it’s you or Claude that want to touch on this but you mentioned you broke all the records.
Can you talk to us a little bit, what happened right during the quarter and why we should think that these improvements should carry forward in the fourth quarter that you were suggesting they were in October?
E. Hunter Harrison
Well, this is not real glamorous, this is just blocking and tackling every day and gets a little bit better every day at it. We’ve had a real focus on quality efforts that affect train speed and so we’ve been working diligently on train speed.
And all these things fit together. Your train speed goes up, you need less assets, your quality improvement, you have less re-crews, you have less deadheads and you build on that momentum.
Now we are at a run rate today of somewhere around, as we speak today, not quarter-over-quarter comparison, but somewhere around 200 miles a car date. People never thought we would achieve that here and it’s not over.
We still can go beyond that level so I think people want us to, that there’s some secret story here. This is just getting a little bit better every day in execution, being sensitive to the needs on the impacts they have and you will continue to see these operating metrics improve.
Now whether we use it for growth in the market or whether we lower cost or a combination. That speed and velocity allowed that reduction in the rolling stock inventory that’s now down to 102,000 cars all lined as we speak.
I can remember the day when I came in, it was 130,000 cars. And the thing people didn’t realize is if you have less cars in terminals, just fewer cars to deal with lowers the operating cost in the terminal which makes the velocity faster.
So it’s really exciting for me to see all this start to come together. We hit a little wall.
2006, we broke records, world records. 2007, we had some headwinds and some weather and some strikes and some other things that set us back, our momentum.
Now we have regained that momentum. We’re back beyond the 2006 level and looking for the next wall we hit.
Operator
Your next question is from Bill Mackenzie – TD Newcrest.
Bill Mackenzie – TD Newcrest
Jim, was wondering if you could maybe talk a little bit more about the metals and minerals segment. One area you guys have had pretty exceptional growth and I was wondering, a lot of those markets through that segment are fairly economically sensitive but you’ve had some great success with some of your customers ramping up.
I was just wondering if you could give us, maybe looking out over the next six to 12 months, how much will the growth over that segment will be from, dependent on customers ramping up production or new customers versus the sensitivity there to the economic outlook?
James M. Foote
Well, we have experienced a growth area in two areas. Obviously, the ore business, the aggregate business, etc.
that’s in there has been driven by economic growth and specific business activity like the oil sands project where we’ve been moving the aggregate out there. The steel business has, in the slab and the sheet, has been associated with economic activity and to some degree, increased activity from production in the U.S.
for exporters. The dollar has moved around and then thirdly, one of the areas where we’ve been helping with the growth has had the industry, the steel industry has consolidated and they have sought efficiencies in their manufacturing activity.
They have changed their production and shipping patterns that has greatly favored rail where everything used to move truck. And so we’ve seen market share gains there.
So I still continue to believe that the oil sands activity will continue and I still believe that we will continue to have market share gains from truck. And so we’ll have to wait to see going forward about the other third of the growth driver here, the economic activity.
When does that, when do we start to see the impact? And if we are impacted with a slowdown, which I think we’ll probably see here in the very near term, when does that come back as we move in ’09?
And I think that right now everyone’s believing that that will be sooner in ’09 than later.
Bill Mackenzie – TD Newcrest
Just a housekeeping question for Claude on the tax rate which, if I’m doing my math right, if I strip out the deferred tax recovery in the quarter, the tax rate would have been around 32.5% which is a little bit higher than were you’ve been tracking the last few quarters. Was just wondering if that was just shoring up some reserves or if that’s the more normalized rate going forward or if we should see it come back to the lower 30 range that we’ve in the last little while?
Claude Mongeau
31% is the number that I’ve been guiding to. It obviously varies by quarter and you’ve seen it in this third quarter but I think 31% excluding the DIC recovery is not a bad number to use.
Operator
Your next question comes from Ken Hoexter – Merrill Lynch.
Chris Weatherby – Merrill Lynch
It’s Chris Weatherby in for Ken. I guess if I could just jump back to Prince Rupert for a second and get an understanding of how the port is ramping and if we’ve seen an increase as you’ve gone through the quarter.
Obviously, there’s some weakness in general; economic weakness that seems to have accelerated as we’ve moved through the quarter. Just get a sense of where volumes were as we moved our way through the third quarter.
James M. Foote
On a weekly basis, on a quarterly basis, off the top of my head I can’t tell you exactly what they were. In October of last year is when the first vessel came in, the first Costco vessel came in so that was like the first level of activity.
In July of this year we saw that the Costco and the alliance there bring another vessel in so basically we’ve doubled the volume in July and so that’s been the ramp up level of activity. We went from one train, I mean one vessel to two and our goal here is to, in 2009 get another vessel in there as well.
Chris Weatherby – Merrill Lynch
Following up on that, is that the capacity, another vessel in there? How much general capacity is left at the port as we look forward into next year?
James M. Foote
I think that’s order of magnitude that’s about right. We get one more vessel calling in then the phase 1 of that facility is sold out.
Chris Weatherby – Merrill Lynch
Just switching gears, Claude, I think you mentioned a bad debt number earlier in the presentation. I missed it.
Just wanted to understand, was there an increase in bad debt and if so is there a specific area you’re seeing any weakness in your customer base?
Claude Mongeau
No, we’re not. We’re obviously monitoring that very carefully but no, the increase is only a $4 million increase in bad debt year-over-year so it’s a small amount.
Certainly, we’re mindful of the current environment but I don’t see any trend that we have issues with collecting our receivables.
Operator
Your next question comes from Cherilyn Radbourne – Scotia Capital.
Cherilyn Radbourne – Scotia Capital
I wonder if you could just speak a little bit about the different business dynamics across your various regions: west, east and south. And just tell us whether there was anything that you did during the quarter to respond to changing demand patterns across those regions.
E. Hunter Harrison
Let me make a couple comments then maybe Jim or Claude might want to comment. Generally speaking, our Eastern Canada operation is seeing the softest business levels and they’ve made the most adjustments relative to their business levels.
Obviously, the paper franchise in the Eastern Canada has been in trouble and we’ve seen depressed business levels. In the U.S., business has been a little better and it’s been a little more up and down throughout the year but right now running pretty good with the addition of the train from Prince Rupert and we’ll pick up more when the grain picks up.
As Jim said earlier, if they were a little bit late in getting in the fields to cut the beans and corn based on weather so I think it’s just a timing issue there but the U.S. is up a little bit.
Western Canada has for the last several years been the strongest growth story related both to Prince Rupert, backhaul opportunities associated with Prince Rupert. Obviously, the project in Edmonton, Alberta, the tar sands and all those issues so we’ve had real strong growth and activity in Western Canada and that’s how we’ve adjusted accordingly.
We reallocated resources, we reallocated people and adjusted to those kind of levels. So if you want to look at that and think of it over two or three years, Eastern Canada’s been down a percent or two a year or so.
The U.S. has been up a percent or two and Western Canada has been boomtown and we expect those trends to probably continue.
Jim, you or Claude want to –
James M. Foote
No.
Claude Mongeau
No, I think that covers it.
James M. Foote
Very good summary.
Cherilyn Radbourne – Scotia Capital
Since no one’s asked a specific question about the EJ&E, I’ll just ask what updates you want to give there and I guess just curious whether we have to wait until after the U.S. election to see something there.
E. Hunter Harrison
We’re working very, very hard. This staff, Jim and I and Karen Phillips from our Washington office.
We went in to see Mayor Daly last week and talk to him about the transaction. Claude has been working very hard on the transaction.
We’re in the courts in Washington, asking the court to require the STB to give us the decision so we can close the transaction prior to the end of the year so we won’t have trouble with our friends at hopefully U.S. Steel.
Now, we’re hopeful that the STB, without court action, will step up and approve the transaction. I think it’s fair to say they have to approve the transaction based on the merits and the competitiveness.
Nobody’s raised an issue about the competitiveness. The only issue has become the quote, mitigation of the environmental issues and we’re perfectly willing and we have said to the court and to the STB that we would, allow us to close based on that it’s not anti-competitive and then we will hold and freeze and have a status quo, not change any operation until they feel like and our comfortable that the environmental issue has been dealt with.
We have had some worthy opponents in Chicago but the fight is a long way from over. I think and I’m hopeful that we will get the transaction done and completed by year end and if there’s any more we’ll let you know.
I do think that given the elections and when the elections are past there could be a little shift in certain areas. I think if you’ve been following it closely and you looked at the various editorials in the various papers and interact with some of the township, I think the momentum has swung back towards a little bit in our favor from where it was at one point in time.
So that’s one of the things I do every night when I get on my hands and knees is talk about the EJ&E and so we hope it’ll all be done by year end.
Operator
Your last question comes from David Feinberg – Goldman Sachs & Co.
David Feinberg – Goldman Sachs & Co.
Most of my questions have been asked so just two broader open-ended questions. One, the last two years the winter has been pretty severe, particularly in Canada.
Wanted to know if you’re making any special preparations or any adjustments to your operations ahead of the winter this year in preparation of perhaps a repeat of the last two?
E. Hunter Harrison
Well, we prepare every year. We have a special process we go through in preparation for the winters.
There’s certain things you can’t prepare very, very well for. I would add this.
We have done one thing. We have added 160 DP to our fleet which is distributive power, if you’re not familiar with that technology where we can put one engine on the head end of the train and one engine two-thirds back or in some cases on the rear end where we get an air supply from more than one place, which allows us to run much longer trains than you would in 30 or 40 below weather.
So where we’ve had to cut train size 30%, 40% in the past, we feel going in this year we’ll be much more better prepared than we have been in the past. We did make some physical changes at Winnipeg and we’re doing one project as we speak to get ready.
We have a little different operating plan that if we get into some of the severe weather that we got into last time, that we can react. We have a contingency plan that says for example, if it gets 40 below above the lakes we’ll run below the lakes.
So there’s a lot of things that we’ve done and learned and will continue to get better at in dealing with the weather.
David Feinberg – Goldman Sachs & Co.
One followup question because there haven’t been enough on pricing. You made mention in the Q&A about we’ll see what happens over the next six months in terms of your outlook for ’09 and base pricing remaining at the 4% to 5% level.
Just trying to get a sense if in fact your pricing strategy is based on the value proposition of your product. What could change over the next six months that would pressure pricing, more hypothetically than anything?
E. Hunter Harrison
Well, Jim is going to comment also. I would say this.
Look, we’re relatively bright people here. If this thing is a horrible storm and we get into real depressed levels of business, we’re not going to a franchise sit out there with people with assets and when the lines [inaudible] that we own and not have some business on it, somebody’s got to pay for the light, gas and water.
I understand that. I don’t think we’re going to reach that point but there’s a point in certain markets that we would have to make adjustments.
If your customers don’t make it that’s not good for us so are we going to try to work with them and help them where we can and help them enhance their product? Sure but I don’t think that any of us think that it’s going to reach any proportions close to that.
James M. Foote
I was going to say that over the last two years we’ve clearly had, not difficult economic times tied to the housing industry and our forest products but clearly depression type levels of activity in that group and now for most of this year, very difficult problems in the auto industry. And during that period of time my pricing activity has been in the 4% to 5% range.
I think you misinterpreted what I said that I would assess mid-2009 and maybe there was upside on pricing going forward.
Operator
That’s all the time we have. I’d like to turn the meeting back to Mr.
Harrison.
E. Hunter Harrison
Well, thanks very much for joining us and we look forward to visiting with you again in January and reporting fourth quarter results that were as nice as these.
Operator
The conference has now ended. Please disconnect your lines at this time and we thank you for your participation.